5 th session: Financial Accounting Measures of Performance

1. 5th session:Financial Accounting Measures of Performance Performance Evaluation IMSc in Business Administration September 2010

2. Financial accounting measures of performance Computing Earnings per Share (EPS)

3. Computing Earnings per Share (EPS) • Earnings per share indicates the income earned by each share of common stock. • Reported at the end of the income statement • Should report intermediate components as well.

4. EPS on Simple Capital Structure • Simple Capital Structure means that there is only common stock and there is no potential common stock (securities that can potentially be converted into common stock and dilute EPS).

5. Preferred Stock Dividends • Preferred Stock Dividends are compensation not available for common stockholders, therefore they are subtracted from the Net Income.

6. Weighted Average Number od Shares Outstanding • Weighted by the fraction of the period they are outstanding • Find the equivalent number of whole shares outstanding for the year.

7. Stock Dividends and Stock Splits • When these happen computation of the average number of shares outstanding needs to be redone. • A stock dividend or split does not change the shareholders’ total investment.

8. Complex Capital Structure • Dilutive securities are securities that can be converted into common stock (through conversion or exercise) and will dilute earnings per share.

9. Diluted EPS Note that: Only dilutive securities are to be reported! Antidilutive are not considered.

10. Diluted EPS – Convertible SecuritiesIf-Converted Method • Conversion of the convertible securities as soon as possible (beginning of period or issuance) • Elimination of related interest, net of tax. • Logic is that if the convertible securities were converted, then they didn’t produce any interest and net income has to be filtered of this.

11. Diluted EPS – Options and WarrantsTreasury Stock Method • Exercise of options or warrants as soon as possible (beginning of period or issuance) • Proceeds from the exercise are used to purchase common stock.

12. Financial accounting measures of performance Financial Analysis through Ratio Computation – a shortcut to evaluating firm’s performances

13. Limitations of Financial Ratios • Not useful in isolation – only valid when compared to other firms or the company’s historical performance • Different accounting treatments – particularly when analyzing non-U.S. firms • Finding comparable industry ratios for companies that operate in multiple industries • All ratios must be viewed relative to one another • Determining the target or comparison value requires some range of acceptable values

14. Financial Ratios – Analyst/Evaluator Considerations • Do firms have similar accounting practices? • Are ratios comparable across firm divisions? • Do different ratios give consistent information? • Are the ratios reasonable for the industry?

15. Interpreting Ratios 1. Cross-sectional analysis: Comparison to industry norm or average 2. Time-series analysis (trend analysis): Comparison to a company’s past ratios

16. Ratio Analysis Context • Company goals and strategy • Industry norms • Ratios may be industry specific • Multiple lines of business distorts aggregate ratios • Differences in accounting methods • Economic conditions • Cyclical businesses and the stage of the business cycle

17. Categories of Ratios Efficiency of day-to-day tasks/operations • Activity • Liquidity • Solvency • Profitability • Valuation Ability to meet short-term liabilities Ability to meet long-term obligations Ability to generate profitable sales from asset base Quantity of asset or flow associated with an ownership claim

18. Ratio Analysis Some general rules: • For ratios that use only income statement items, use the values from the current income statement • For ratios using only balance sheet items, use the values from the current balance sheet • For ratios using both income statement and balance sheet items, use the value from the current income statement and the average value for the balance sheet item

19. Integrated Financial Ratio Approach • Important to analyze all ratios collectively • Use information from one ratio category to answer questions raised by another ratio • Classic example = DuPont analysis

20. DuPont System: Original Equation Net Income ROE = Average Equity Net Income Revenue Revenue Average Total Assets Average Total Assets Average Equity × × Net Profit Margin Asset Turnover Leverage

21. DuPont System: Extended Equation Average Total Assets Average Equity Net Income Revenue Revenue Average Total Assets × × EBIT Revenue EBT EBIT Net Income EBT × × EBIT Margin Interest Burden Tax Burden

22. DuPont System: Extended Equation EBIT Margin Interest Burden Tax Burden Asset Turnover × × × × Leverage Operating Profit Margin 1 – Effective Tax Rate

23. Per Share Ratios – for Valuation Price Per Share P = E Earnings Per Share Price Per Share P = CF Cash Flow Per Share Price Per Share P = S Sales Per Share Price Per Share P = BV Book Value Per Share

24. Per-Share Quantities NI – Pref Div Basic EPS = Weighted Ave # Ordinary Shares Income Adjusted for Dilutive Securities Diluted EPS = Weighted Ave # Shares Adjusted for Dilution CFO Cash Flow per Share = Weighted Ave # Shares

25. Dividend Related Quantities Common Dividend Dividend Payout Ratio = Net Income – Pref Div Net Income attributable to common shares Net income attributable to common shares – common dividend Retention Rate (b) = Net income attributable to common shares

26. Dividend Related Quantities Sustainable Growth Rate = b × ROE Retention Rate 1 – Dividend Payout Ratio Return on Equity

27. Sustainable Growth Rate – Problem A firm has a dividend payout ratio of 35%, a net profit margin of 10%, an asset turnover of 1.4, and an equity multiplier leverage measure of 1.2. Estimate the firm’s sustainable growth rate. Growth rate =b × ROE (1 – 0.35) 0.1 × 1.4 × 1.2 = 0.1092 = 10.92%

28. Evaluating Past Financial Performance • How have key ratios changed and why? • How do key ratios and trends compare with competitors/industry? • What aspects of performance are critical for a competitive advantage? • How did the company perform in these areas? • What is the company’s business model and strategy – are they reflected in key measures?

29. Projecting Performance • Forecast expected GDP growth • Forecast expected industry sales based on historical relationship with GDP • Consider expected change of firm’s market share • Forecast expected firm sales • Use historical margins for stable firms (gross, operating, net) or individual forecast for each expense item • Remove nonrecurring items • Historical margins are not relevant to new, volatile, or high fixed-cost industries